NEW YORK UNIVERSITY FINANCIAL ECONOMICS Spring 2003 Franklin Allen and Douglas gale Topic 1: What is Corporate Finance? Readings A Ph. D. textbook that provides basic coverage of some of the main topics is J. A. de Matos. Theoretical Foundations of Corporate Finance, Princeton: Princeton University Press, 2002) There are many MBa textbooks. A very good one is R.A. Brealey and S.C. Myers, Principles of Corporate Finance, 7th edition(New York McGraw Hill, 2002) 1.0 Introduction Corporate finance is concerned with how firms should make investment and financing decisions. It is at the heart of most MBA programs. In recent years it has also become an important part of financial economics. In this course we will cover the subject at an advanced level by first developing the economic tools that are used in the subject and ther applying them. In this first part of the course we will start by briefly outlining what corporate finance focuses on. We will do this by outlining the coverage of a typical MBA course. As a comparison of the two books above will show this is somewhat different from what is usually studied in Ph. D courses. These usually cover a subset of what MBA courses
1 NEW YORK UNIVERSITY FINANCIAL ECONOMICS II Spring 2003 Franklin Allen and Douglas Gale Topic 1: What is Corporate Finance? Readings: A Ph. D. textbook that provides basic coverage of some of the main topics is: J. A. de Matos. Theoretical Foundations of Corporate Finance, Princeton: Princeton University Press, 2002). There are many MBA textbooks. A very good one is R.A. Brealey and S.C. Myers, Principles of Corporate Finance, 7th edition (New York: McGraw Hill, 2002). 1.0 Introduction Corporate finance is concerned with how firms should make investment and financing decisions. It is at the heart of most MBA programs. In recent years it has also become an important part of financial economics. In this course we will cover the subject at an advanced level by first developing the economic tools that are used in the subject and then applying them. In this first part of the course we will start by briefly outlining what corporate finance focuses on. We will do this by outlining the coverage of a typical MBA course. As a comparison of the two books above will show, this is somewhat different from what is usually studied in Ph. D. courses. These usually cover a subset of what MBA courses
cover. This is unfortunate as many interesting topics with important research questions are left out It is important that you read an MBa textbook. I would suggest Brealey and myer as it introduced the current way in which mba courses are taught. It is quite readable and should take only two or three days to finish It is perhaps helpful to start with a brief historical account of where corporate fina comes from. The railroad companies in the US began to use discounting techniques to make investment decisions. Irving Fisher's book on the Theory of Interest was quite influential However, the corporate finance that was taught in business schools before the Second world War was still very much based on the law. Arthur Stone Dewing's classic book on Corporate Finance which was originally written in the 1920s essentially described various financing instruments and legal precedents. After the war books began to move more towards an accounting and economics based approach. Jack Hirshleifer's 1970 book was q influential in making the subject more economics based. Brealey and Myers was the first book when it was published in the late 1970's was the first to properly incorporate the modern foundations of corporate finance which are Fishers separation theory, the Gordon Growth model, the Modigliani-Miller theorems, the Capital Asset Pricing Model and efficient markets In what follows we will start with firm's investment decisions and then consider the financing aspects
2 cover. This is unfortunate as many interesting topics with important research questions are left out. It is important that you read an MBA textbook. I would suggest Brealey and Myers as it introduced the current way in which MBA courses are taught. It is quite readable and should take only two or three days to finish. It is perhaps helpful to start with a brief historical account of where corporate finance comes from. The railroad companies in the US began to use discounting techniques to make investment decisions. Irving Fisherís book on the Theory of Interest was quite influential. However, the corporate finance that was taught in business schools before the Second World War was still very much based on the law. Arthur Stone Dewingís classic book on Corporate Finance which was originally written in the 1920ís essentially described various financing instruments and legal precedents. After the war books began to move more towards an accounting and economics based approach. Jack Hirshleiferís 1970 book was quite influential in making the subject more economics based. Brealey and Myers was the first book when it was published in the late 1970ís was the first to properly incorporate the modern foundations of corporate finance which are Fisherís separation theory, the Gordon Growth model, the Modigliani-Miller theorems, the Capital Asset Pricing Model and efficient markets. In what follows we will start with firmís investment decisions and then consider the financing aspects
1.1 Investment decisions Objective Function of the Corporation Motivation Example 1 Suppose you are at a gm shareholders'meeting. Three of the shareholders there have very different ideas about what the firm should do Old lady Wants money now. Wants gm to invest in large cars since this would yield a quick profit Little boy's trust Wants money a long way in the future. Wants gm to invest in fund representative building electric cars Pension fund Wants money in the medium term. Thinks there will be a very serious oil crisis some time in that period. Recommends that GM build small cars What should gm do? We will see how to answer this question by looking at how an individual should make investment decisions. Once we see that we can see how a corporation should make investment decisions Example Bill ross has inherited $1M. He grew up in Europe and has developed a real aversion to work, which he completely detests. He therefore plans to use his inheritance to finance himself for the rest of his life. For simplicity we'll divide his life into two periods youth and old age. Also, we're going to assume that there is only one financial institution, a bank, which lends and borrows at a rate of 20%, so that for every dollar deposited in youth S1.20 is received in old age 3
3 1.1 Investment Decisions Objective Function of the Corporation Motivation Example 1 Suppose you are at a GM shareholders' meeting. Three of the shareholders there have very different ideas about what the firm should do. Old lady: Wants money now. Wants GM to invest in large cars since this would yield a quick profit. Little Boy's trust Wants money a long way in the future. Wants GM to invest in fund representative building electric cars. Pension fund Wants money in the medium term. Thinks there will be a very representative serious oil crisis some time in that period. Recommends that GM build small cars. What should GM do? We will see how to answer this question by looking at how an individual should make investment decisions. Once we see that we can see how a corporation should make investment decisions. Example Bill Ross has inherited $1M. He grew up in Europe and has developed a real aversion to work, which he completely detests. He therefore plans to use his inheritance to finance himself for the rest of his life. For simplicity we'll divide his life into two periods, youth and old age. Also, we're going to assume that there is only one financial institution, a bank, which lends and borrows at a rate of 20%, so that for every dollar deposited in youth $1.20 is received in old age
Bank alone Assuming this bank is the only opportunity open to Bill, what can he do? 12M ope=-1+r)=-12 S spent in youth (i He could go on a fantastic trip around the world, spend the whole $IM, and then live in poverty with nothing for his old age (i) He could spend $O5M in his youth, have a moderate lifestyle, put $O.5M in the bank, and still have $0. 6M for his old age (iii He could put all his money in the bank for his old age and spend nothing in his youth, so that he can take an even better trip around the world in his old age. In this case he gets(0, $1. 2M) (iv) If we consider all the other possibilities, we get a straight line between(i)and He can thus consume anywhere on the straight line between SIM in youth and $1. 2M in old age. Analytically we have CoA =1.2M-1.2 CY
4 Bank Alone Assuming this bank is the only opportunity open to Bill, what can he do? (i) He could go on a fantastic trip around the world, spend the whole $1M, and then live in poverty with nothing for his old age. (ii) He could spend $0.5M in his youth, have a moderate lifestyle, put $0.5M in the bank, and still have $0.6M for his old age. (iii) He could put all his money in the bank for his old age and spend nothing in his youth, so that he can take an even better trip around the world in his old age. In this case he gets (0, $1.2M). (iv) If we consider all the other possibilities, we get a straight line between (i) and (iii). He can thus consume anywhere on the straight line between $1M in youth and $1.2M in old age. Analytically we have COA = 1.2M - 1.2 CY
Projects Alone Were next going to look at the case where there is no bank and there are only productive opportunities or projects that allow him to transfer wealth from his youth to hi Bill fancies himself as an entrepreneur and sits down to work out what investments he can make. He ranks them in terms of profitability with the most profitable being first and the least profitable last C OA Production Possibility urve 34M A+B 2M A 86.MC Project A Bill is a wine lover. He estimates that a small vineyard that has recently come on the market will cost him $50,000 now and will yield him $200, 000 for his old age. This is the best project he can think of. Hence, if he invests just $50,000 in this project and consumes $950.000 now. he can still consume $200.000 in his old age Proiect B Bill is also a gourmet. The next best project he can think of is to run a restaurant in the town he lives in. He reckons for a $100,000 outlay now he can get $140,000 in his old
5 Projects Alone We're next going to look at the case where there is no bank and there are only productive opportunities or projects that allow him to transfer wealth from his youth to his old age. Bill fancies himself as an entrepreneur and sits down to work out what investments he can make. He ranks them in terms of profitability with the most profitable being first and the least profitable last. Project A Bill is a wine lover. He estimates that a small vineyard that has recently come on the market will cost him $50,000 now and will yield him $200,000 for his old age. This is the best project he can think of. Hence, if he invests just $50,000 in this project and consumes $950,000 now, he can still consume $200,000 in his old age. Project B Bill is also a gourmet. The next best project he can think of is to run a restaurant in the town he lives in. He reckons for a $100,000 outlay now he can get $140,000 in his old